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May 25, 2007 12:38 pm
It has been almost six months since the much heralded shake-up of the property investment market which saw the introduction of Real Estate Investment Trusts (Reits) but already analysts are warning their days might be numbered.
Lehman Brothers’ Mike Prew has pronounced the 14 listed property companies that have converted into Reit status or announced plans to do so are “living on borrowed time”, which will come as a shock to those who listened to promises of a revolutionary new asset class.
There are certainly some facts that make uncomfortable reading to the average investor looking to buy into Reit shares. UK Reits are the worst performing in the world so far this year: Britain is the only country where Reits are trading at a consistent discount to the net value of the underlying assets.
Reits normally trade at a premium to net asset value thanks to their tax-efficient structure. In France, for example, Reits can trade at premiums of as much as 50 per cent, while average premiums of around 35 per cent
globally are not unusual.
UK Reits started the year on 10 per cent premiums to underlying net assets but investor sentiment has quickly changed, pushing most Reits to significant discounts. The two industry giants in the UK, British Land and Land Securities, are now trading at discounts of around 10 per cent.
Even a set of reasonably sound results from the pair in the last two weeks only dragged down their share prices further.
Francis Salway, chief executive of Land Securities, gave a bearish statement on the property market, suggesting that capital growth is now relatively difficult.
This is at the heart of the Reit market’s woes, according to Prew. He says sluggish capital growth, coupled with low dividend yields from the major Reits has made the sector unattractive to investors. “There were expectations of a situation similar to European Reits, which trade at a premium, but low capital growth and dividends do not make a persuasive argument,” Prew says.
JP Morgan analyst Harm Meijer has also downgraded the sector against equities: “The risk/return profile is not fantastic. We would argue that while some of the sell-off is overdone, there is no hurry to put your money into the sector at the moment.”
But John Gellatly, global chief investment strategist at fund manager Blackrock, says investors should not take fright at the short- term performance of Reits, pointing to overseas markets such as the US and Japan where it took several years before the retail market became convinced by these property funds.
He says the market is inevitably slowing because the advantages – notably more generous tax treatment – of Reit conversion were priced into quoted property companies last year.
“By last summer, we knew we were going to get Reits. But the tax advantages have not been acknowledged. It will be a slow burn – in the US and Japan retail investors have become very important but only over time.”
Reits enjoy exemption from UK corporation tax on income and capital gains, and, in return, distribute to shareholders a minimum of 90 per cent of exempt income in the form of dividends. At an investor level, this means the effective rate for a basic rate taxpayer falls to 22 per cent, from 30 per cent, and for a higher rate taxpayer to 40 per cent from 47.5 per cent.
Phil Nicklin, partner at Deloitte and a key figure behind the drafting of the Reits legislation, says the benefits of investing in Reits are obvious, but seemingly lost in translation to investors. “I don’t think people realise how good the tax benefits are,” Nicklin says. “When a company becomes a Reit, it’s basically the same company with a new efficient tax system.”
Patrick Sumner, head of property equities at Henderson Global Investors and chairman of Reita, the Reit advisory group, admits that private investors have so far had little interest in the Reits market. “Investors have moved on to the next pretty girl. Equities, for example, are regarded as better-looking at the moment,” Sumner says. He should know better than most – for the past six weeks, he has been on a gruelling countrywide road show trying to sell the concept of Reits to independent financial advisers.
Before the Reita tour set off, its research showed only 23 per cent of advisers felt secure in recommending these property funds as investments. Sumner says it is the private investor who is crucial to the long- term future of the sector. “The IFAs think the market has reached a peak but we explain that there are several property markets, all at different points, and Reits are part of a balanced investment portfolio,” says Sumner, who this week was taking the message to the advisers in the northwest.
“It took 15 years to catch on in the US and it was after a similar outreach programme. The fundamentals are there. You’ll still get 7 or 8 per cent returns on a pretty sustainable basis in property, and this goes into double digits with good management. We’re not saying that people should bet the ranch on Reits, but audiences are going away reassured.”
The property market has enjoyed an unprecedented boom period in recent years. Last year, it outstripped UK equities and bonds with a total return of 18.1 per cent, according to IPD data, marginally less than the 19.1 per cent return for 2005.
But many commentators are taking the sharp increase in prices as a sign that the market is nearing the top of its investment cycle, which means little in the way of capital growth. Dividends on Reits, meanwhile, are also relatively low, typically between 2.2 per cent and 2.5 per cent.
Dividends from traditional property companies are unlikely to increase as long as property yields remain low, but there is a new class of Reits expected to hit the market in the next few months that could offer investors better returns.
The most significant of these new Reits so far is Vector, masterminded by Richard Balfour-Lynn, chief executive of Alternative Hotel Group, that comprises £2.6bn of hotels and conference centres that will be floated as a Reit next month. The company was this week on a roadshow for the public offer, and not able to comment, but sources close to the process say the reaction has been positive from private investors, who, it is hoped, will make up to 15 per cent of the share base. Orders began to be taken this week.
Vector has positioned itself purely as an income and cash flow investment, paying quarterly dividends that are expected to be slightly less than 5 per cent a year, and promises of annual inflation-linked rental increases; they claim little risk of a fall in value. Effectively, the investment would be similar to a long-term, high-yielding bond, potentially attractive to some investors compared with the low dividend payouts of more traditional property companies.
If it proves a success then the floodgates could open to any number of pub, hotel, nursing home or health club Reits.
The government recognises the importance of new property businesses such as these to the future of Reits. It is consulting on a number of measures to make it easier for newly-established companies such as Vector to convert into Reits.
“We have got 14 Reits with a market capitalisation of more than £35bn,” says a Treasury spokesman, “which is a very successful starting point. But we’re not complacent at where the market is. We hope to see many more Reits in the near future.”
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